How To: Pricing Proposed Projects and Estimating Labor Costs
First, a quick programming note: I’ve renamed this newsletter to “Time & Materials”, an homage to the nature of the business I write about most often. It’s apropos given the topic of this week’s newsletter.
Time & materials (T&M) projects are the easiest professional services proposals to price, yet they are often where services businesses get into trouble. Labor costs of billable staff are usually the largest single expense category for a professional services company. Estimating the gross margin of a project accurately is critical to running a profitable services business.
So, how do you avoid the pitfalls of pricing mistakes eroding your profit? It starts with accurately estimating a project’s gross margin…
Labor Cost Estimation Techniques
Estimating a project's gross margin requires estimating the actual costs of the staff being used to deliver the work. The difference between the revenue generated by the billable staff (their rates) and their costs is your gross margin. But first...
Why Not Use Actual Labor Costs?
It's tempting to try to use actual labor costs. If you have a small team, actual labor costs may be easy. The challenges with actual labor costs creep in quickly, though:
1. Changing staff on a project can cause gross margin surprises. If you have to make a staffing change on a project, the chances that the new staff member costs exactly the same as the staff they are replacing is low. Other pricing strategies will help ensure that your gross margin doesn't fluctuate by surprise when staffing changes occur.
2. As more people are involved in pricing projects, using actual labor costs becomes more complicated. As services companies grow, more people typically get involved in pricing a proposed project. When only one person (typically someone senior in the company) is doing pricing, it's easy for them to know how much every billable staff member costs (i.e., how much they make and their fully loaded cost). This becomes more complicated and more sensitive as you have more people. You may not want everyone responsible for pricing projects to know everyone's salary. Even if you did, you'd have to keep the people pricing projects abreast of salary changes.
3. Every time you add billable staff members to the company, you have a new expense to track. This makes it hard to keep pricing calculators up-to-date and easy to use.
Single Blended Hourly Cost
A single, blended hourly cost is the easiest solution for small teams that are typically doing the same type of work without wide pay ranges. If all billable staff are roughly "fungible" in terms of the type of work they can do, this makes pricing deals really simple. In this model, you calculate the average fully loaded cost (i.e., inclusive of the costs of all benefits, etc.) of all billable staff.
Once you know the average cost (hourly, daily, weekly, etc.) of billable staff, then it's simple to estimate the gross margin: (billable rate - average fully loaded cost) / billable rate = gross margin. (This assumes that there were no non-billable expenses for simplicity - more on this in a different post!)
Hourly Cost Based on Skill / Discipline
The single blended hourly cost often breaks down when you have different skill sets or disciplines billable on projects where the staff members have different salary ranges. For example, you may have two or more different skill sets billing time on the same project. Each skill set may command a different hourly rate, and the staff performing that work may be compensated very differently.
A typical example of this is a project that has software engineers, visual designers, and a specialized skill set, like machine learning, all participating on the project. In such cases, the fully loaded costs of each type of resource are usually very different. Using a single blended hourly cost won't be accurate.
The simplest solution is calculating the average fully loaded cost by skill set or discipline. In this model, you apply the single blended hourly cost approach to each group of billable staff with a particular skill set or discipline to determine each group member’s fully loaded costs. From there, you calculate an hourly rate for each skill set and then can easily calculate the gross margin.
Hourly Cost Based on Seniority
This is a variation of the skill/discipline cost model. Instead of grouping billable staff based on skill or discipline, you group them based on seniority. If you have groups of billable staff with the same skill set but varying levels of seniority, it can be helpful to have some title or grade system corresponding to seniority. That title or grade is used when you present billable staff in each group to the client (e.g., junior-, mid-, or senior-level engineer) with different rates. Presumably, there are also different expectations about the work product by seniority.
Similar to the hourly cost model based on skill or discipline, you can calculate the average fully loaded cost for each seniority group. Based on billing staff at different levels of seniority to a client at different rates, you can easily calculate the gross margin for the project.
With a large or diverse enough bench, it may be necessary to adopt a hybrid of both skill set and seniority-based rates. In that model, you may have a rate card for the various permutations of skill levels in each discipline you have employees.
Other Gross Margin Estimation Considerations
Correctly estimating gross margin is necessary to be able to accurately predict the profitability of the business. Selecting the correct approach above is an important first step, but there are three places where errors often creep into gross margin estimation that can undermine the value of the exercise.
Billable Hours / Days In a Month
Each month of the year can vary slightly in terms of the number of billable hours or days in the month. Things like the total number of days in the month, where days fall on the calendar (i.e., # of weekdays vs. # of weekend days), and holidays all affect the number of billable days. When forecasting revenue, it's critical to know how many billable days are in the month and use that as the basis for the number of hours you're starting with to estimate revenue from each project. This has a material effect on gross margin because the amount of revenue generated by a billable staff member can change month-to-month, even if the project they are working on and their rate stays the same.
Accounting For Paid Time Off
Paid time off, like for illness or vacation, will occur in every business. Making allowances for it in your gross margin forecasts is critical. One of the most simple ways to do this is to review historical time card data to see the average number of days of absences in a month. You can then apply a percentage of missing days that decreases the number of billable hours on the project. Using this technique when forecasting future months’ revenue helps account for decreases in revenue that will degrade your gross margin.
A slightly more sophisticated forecasting model takes seasonality into account. In the United States, people tend to take more time off in November and December due to the Thanksgiving and Christmas holidays and in the early summer months. Over time, you may find that you can more accurately forecast the % of days off on a month-by-month basis and apply a variable adjustment to billable hours based on the month.
Consistency & Making It Easy
Gross margin estimation must be easy for people to do and be done consistently to avoid errors. The simplest way to do this is to create a "margin calculator" as a Google Sheet or Excel workbook that must be used by anyone involved in pricing a project. The calculator should hard code the input parameters for labor costs (based on the model you choose from the list above) and assumptions around the number of billable days and the PTO adjustments you believe is appropriate.
The only inputs the person pricing the project needs to provide on their own is the number of staff (potentially by skill set/discipline or by seniority, depending on your pricing approach), the duration of each staff member’s engagement on the project, and their billable rate.
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This is one of the best overviews of Gross Margin in a consulting/people business. It's such a simple concept, but is so often overlooked with a focus just on revenue growth. Revenue is critical, but without gross margin, you don't have a business and you won't make it up in volume!